As we digest the impact of the Fed’s surprise 100 bps rate cut on Sunday, we thought it would be interesting to compare and contrast the Fed’s actions this time around with what they did as the Global Financial Crisis (GFC) of 2008/2009 unfolded, and what the market’s reaction was back then, and has been thus far today.
1) Fed Rate Cuts – They’ve Done Pretty Much All That They Can Do With Rates
At the beginning of the GFC, the Fed acted quickly to cut rates in order to reduce borrowing costs in the hopes that capital would continue to flow after Lehman was allowed to go under. The Fed cuts rates 3 times over a 2 month period, bringing rates down from 2.0% to 0.25%.
With the surprise rate cut last night, the Fed has now from rates down from 1.75% to 0.25%. However, this time they did so over a 3 week period, so are clearly acting quickly, and showing that they will do what needs to be done.
2) Asset Purchase Program (QE) – The Fed Has Only Just Begun
At the onset of the crisis, the Fed initially announced $800 billion of asset purchases. Last night they announced $700 bio. During the GFC the Fed’s balance sheet expanded to $4 trillion. Clearly, they will do more QE as required.
3) Satisfying Demand for USD Funding – Powell Is Going To Have To Do More
During the GFC the market demand for USD funding was huge, and the Fed did everything in its power to ensure adequate access to USD funding. That need for USD funding has grown substantially since the GFC and even though the Fed announced USD swap lines in concert with 5 other central banks, the basis between EU rates and US rates shows that these efforts have not calmed the markets. Looking at the charts below, this basis has the potential to get far worse. (The dotted green area in Chart 1 shows the early stages of the GFC so as to compare with where we are today (Chart 2)).
As can been seen whilst the EU-US basis has moved quite a bit today, it is nothing compared to the move we saw during the GFC, at least not yet. During the GFC, the basis blew out to -200 bps. Thus far we’ve only seen this move to -71 bps. Time will tell if the Fed’s actions have been enough to avoid this price action, but it seems unlikely. The Fed will need to do a lot more to satisfy the current demand.
4) Does the Reduced Rate Differential Mean the USD Will Sell-Off? Too Early To Tell
This is the question that many are asking themselves. As we know, interest rate differentials between the two countries of a currency pair play a significant part in the value of the pair. The USD has had significantly higher interest rates than the rest of the G7 for a number of years, but now that difference has been either significantly reduced or has disappeared altogether depending on the currency pair. In ‘normal’ markets one would assume that this could put significant downward pressure on the USD. As can be seen from Chart 1 above, as the US cut rates during the GFC we saw EURUSD come off sharply. Back then however, US rates remained well above Eurozone rates, as the ECB cut rates well below zero. Thus far in response to Covid-19, the ECB has not cut rates further whilst the Fed has cut aggressively. It remains to be seen whether the flight to safety will continue to support the USD or if the reduced rate differential will result in a sell-off of the USD. Personally, given the continued acceleration of the Coronavirus and government’s actions to slow the spread of the disease, flight to safety will dominate markets for the time being.
5) Is the Oil Sell-Off Finished? There’s Likely More To Come
The impact on global demand is still being digested by markets, but the likelihood is that with government actions continue to cause a slowdown in demand (as people work from home, non-essential retail stores are being closed, travel has come to a standstill, and the impact on supply chains is still to be determined), the global economy is heading towards recession if it’s not already there. Demand for oil will continue to decline in the short run, and therefore oil likely has further to fall. As Chart 3 shows, during the GFC, WTI prices came lower by almost 71% as it’s worst point (albeit from much higher levels). Chart 4 shows that to date, we’ve only seen a 45% decline.
For those commodity currencies with significant contribution to GDP from oil, a continued sell off in oil will result in further downside in their domestic currency (CAD, NOK).
It’s very early days in the newest crisis, and it truly is different from anything we’ve ever experienced before. We will only be able to fully analyze the effectiveness of central bank action on the markets, but we would do well to learn from history.
Author: John Glover